The One Thing to Watch
Watch the donut, not the hole
People of a certain age remember a kid’s TV show called Captain Kangaroo. One of the little tidbits the Captain shared was the motto above. There was even a song about it. If you like, take a couple of minutes and give it a listen. https://www.youtube.com/watch?v=tzV-8TofHTw
As an accountant and student of business I have read a good deal about accounting ratios. There’s the Quick Ratio (liquid assets + current receivables/current liabilities) of course which bankers an investors use to decide if a business is even alive. Or there is its cousin, the current ratio (current assets/current liabilities) which tests a companies ability to suddenly pay off its debts. And there are the activity ratios whereby the speed with which a company turns over its inventory is measured (Cost of goods sold/average inventory).
There are others as well. Any MBA student can explain them in great detail. You could check the following for one good summary http://www.aaii.com/journal/article/16-financial-ratios-for-analyzing-a-companys-strengths-and-weaknesses. And there are other similar pieces.
I want to draw your attention to the only one I consider important for small businesses–real businesses–businesses like yours. That ratio is return on investment, or ROI. For me, it is the donut to watch.
First off, let me explain why the accounting profession has such a plethora of ratios, and I have only one. The answer is simple: real businesses have only one concern and that is profit. Since profit comes only from bringing in more money than you spend, the return you get on each dollar spent is what makes the difference. In general, only those businesses large enough to be examined by shareholders, or banks or venture capitalists have need of turnover ratios or debt ratios.
Real businesses are owned and operated by individuals who can observe whether an item is a good seller or not. You don’t need a ratio to see that the Chatty Betty doll is a stinker while the Lacy Tracy doll sells like hot cakes. You know it because you have to dust the Chatty Betty doll boxes, while Lacy Tracy’s shelf spot is always empty.
Real businesses are owned and operated by individuals who don’t want to have any debt. But when debt is unavoidable, they only want the one and they concentrate on paying it off. You don’t need a ratio to explain that approach.
Second, let’s explore ROI a bit more fully. I want to warn you that you probably won’t find this discussion in any accounting book. What I want to say is both broader and, at the same time, more focused than a text book explanation.
So, with that in mind, let’s start.
It costs money to operate a business. The amount it costs varies from business to business. If you are starting a machine shop for job lots there is a good deal of equipment that must be purchased before the first widget can be turned out. Large sums, what we call capital investment. But, if you are starting a messenger service, your only costs are probably business cards, gas for your car or truck, and a commercial rider on your auto insurance.
And in both of those cases, the out of pocket amounts may be very much smaller than the total payout. You may be able to borrow the money for your first lathe, and you can certainly pay your insurance by the month. When you look at your bank accounts, the thing you watch is whether there is money in the operating account to pay the next premium or loan payment
The real issue is that it costs money to do either of those businesses. And the return is the income generated by the activity that the money is spent on. The fact is that the dollar amounts vary widely between those two businesses. Yet using a ratio of the amount brought in versus the amount spent makes it easier to wrap your head around the position of the business.
You want your ROI to be high, simply because it means more profit. The return you receive is the income less the costs of that income. By dividing the return by the costs, you get a ratio, usually expressed as a percentage. A positive percentage represents profitability and a negative percentage represents a loss. Simple as that. Easy to calculate, and easy to understand.
But this goes even further. If the overall business has an ROI of x, can that be used to make judgments about individual aspects of a business? Well here is answer is both yes and no.
Let me give you an example–the cost of acquiring a new customer. If I sell a widget for $50 it makes little sense to spend $75 in acquiring that customer. Right? After all, I am operating a real business without stuff like loss leaders to make up for such a low price. Right?
Let’s pull back a bit and take a higher level view. Most businesses, even real businesses, continue to operate over time. At least, I hope you plan to be in business for a while. Well, that time factor makes a big difference. There are two possible aspects: additional offerings and repeat business.
Additional offerings are the “Do you want fries with that?” portion of a sale. That question may come at the same time as the original sale, or later on in the relationship with the customer. Successful real businesses plan for and develop additional offerings in the form of new products or services or substantial improvements on the current ones.
Repeat business is fairly self explanatory. My base product is preparing a tax return. Clearly, this is something that likely will be repeated year after year with my clients. In fact, on average my clients have a 10 year history with me.
That brings us to the point–lifetime value of a customer. It’s necessary for each business owner to determine as quickly as possible what the lifetime value of a client will be for their business. Because that is the return that you must use in the ROI calculation. So in the case we are considering here, If I spend $75 to acquire a client will likely buy 6 widgets in his lifetime, that makes his lifetime value $300, and the ROI is very positive, indeed.
So, while a single aspect may not meet the needs of a positive ROI, the overall impact of that single aspect will. This is the kind of analysis that every business owner must do to determine the effectiveness of their business spending.
This is related to the value proposition, but not exactly the same thing. But it is imperative to realize that you can’t just run a business “by the numbers” without understanding what the numbers are and what they mean.
So, as your assignment for this week, give me a comment on whether you have ever calculated the lifetime value of a client? Or, if you would rather, comment on some other aspect of business cost that is not a simple as it might appear.